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28 December, 2018  ▪  Maksym Vikhrov

Disorder on the tracks

Why Ukrainian Railways is unable to drive Ukraine's development

This autumn, Ukrzaliznytsia (UZ, Ukrainian Railways) has been behind a lot of positive newsworthy events. In October, the first modernised passenger carriage, equipped with a separate climate control system in each compartment, was unveiled to the public. These wagons will be recognisable thanks to the new logo that the company presented in September. In November, there are plans to launch a 24-hour express service between Kyiv and Boryspil Airport. However, all these events are still unable to take away the image of UZ as one of the most problematic (and at the same time strategically important) companies in the country. Its main trump card is irreplaceability: if pipelines are not taken into account, UZ is responsible for 65% of the country's freight traffic (State Statistics Service, 2017). The railways account for less than 4% of total passenger numbers, but its share in terms of passenger-kilometres is 28%, since it remains the most accessible and safest means of inter-regional transport (State Statistics Service, 2017).

This situation – in essence, a natural monopoly – opens up wide opportunities for development, but UZ is in constant disorder. In 2014, a catastrophic year for the entire country, the company's losses amounted to UAH 15.4 billion ($550m), then 16.7 billion ($600m) in 2015, 7.3 billion ($260m) in 2016 and only in 2017 did it make a profit of UAH 100m, or $3.6m (Ernst & Young, 2018). It remains unclear whether 2018 will end with a positive balance. In addition to financial problems, UZ is often the target of harsh criticism. The government accuses it of inefficiency, anti-corruption authorities make allegations about corrupt deals, passengers are dissatisfied with prices and service quality, and manufacturers are unhappy about tariffs and the chronic lack of transportation capacity. Solving all these problems has been more difficult than expected: since 2014, the company has seen eight different managers, but a miracle has not yet occurred and the crisis has not been overcome.

The main problem that constantly looms over UZ is the fact that passenger traffic is operating at a loss. According to the acting chairman of the company's board, Yevhen Kravtsov, in 2017 losses in this segment reached UAH 10 billion ($360m), in 2016 – 8.8 billion ($315) and in 2015 – 4.5 billion ($160m). This forces the company to apply cross-subsidisation, offsetting losses from passenger transportation at the expense of freight. Experts usually have a negative view of this practice. What's more, UZ itself is supposed to do away with cross-subsidies as soon as next year in accordance with the current targeted state programme for the reform of rail transport. However, the issue here is not the timing, but what is objectively possible. At first glance, it should be feasible to overcome the unprofitability of passenger traffic by increasing tariffs to market levels and improving service, which will make rail transport more competitive and attractive to the consumer. UZ is already moving in this direction. During 2018 – in May and October – ticket prices have risen by 24%. In addition, the company plans to split passenger transportation into three classes according to the speed and comfort level by the end of the autumn: the cost of tickets for economy-class trains will be regulated by the state, while the pricing policy for the rest (standard and comfort) will be determined by UZ. In order to improve service, an electronic system is being developed through which passengers will be able to wait for available tickets on "sold-out" trains. This innovation should be hailed, because the company has long been in need of modernisation. However, it will not be possible to solve the problem of unprofitable passenger transportation in this way alone.

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Firstly, there is a limit to the population's purchasing power, after which an increase in prices will lead to a drop in demand, no matter how comfortable the carriages and how fast the trains will be. Secondly, the pursuit of profitable passenger transport is in fact more about the philosophy of the process than the result – even in EU countries, state subsidisation of rail transport is a standard, long-standing practice. Indeed, as of 2012, the total revenue of the EU rail network was about 112 billion euros, of which 31% came from state subsidies, 41% from passenger transport revenues and 18% from freight revenues. Although the level of government subsidies in various EU sectors is tending to decrease (from 2% of GDP in the 1980s to 0.5% of GDP in the first half of the 2010s), there is no hurry to stop supporting the railways (European Journal of Business and Economics, 2013). In 2006-2011, the average subsidy amount paid to the rail sector in the EU was €41.3 billion a year (European Commission, 2016). By no means is this a waste of money: railway infrastructure also performs a social function, so the negative consequences of abandoning it will exceed the cost of subsidies. Of course, this does not mean it is unnecessary to look for a better economic balance, but passenger transportation is unlikely to become profitable for UZ, at least in the near future.

Therefore, it is only possible to abandon cross-subsidisation if state support is provided, otherwise a collapse will occur either in the company itself or in a society that will have to face the consequences of transportation running at a total loss. The situation with suburban trains is a striking illustration of this. Indeed, in October, city trains in Kyiv were blocked in protest against a lack of carriages. In August, angry passengers did the same thing to a Lviv-Sianka service. In Pustomyty in May and Sknyliv in April, lines had to be closed due to demonstrations on the tracks. The quality of existing carriages and comfort level do not usually stand up to scrutiny. The main reason is the unprofitability of this segment, since UZ regularly receives less compensation than it should for the travel of concession holders, which make up about half of the passenger traffic for these trains. According to the company, regional budgets reimbursed less than 15% of the transportation costs for these categories of citizens in the first 11 months of 2017, racking up UAH 352 million ($12.5m) of debt. In 2016, only 10.4% was compensated and 39.7% in 2015. Obviously, upgrading and improving services is out of the question under such conditions. The fact that this situation repeats itself every year indicates the tremendous weakness of state institutions that are unable to deal with simple settlements. In search of a way to optimise costs, UZ has suggested replacing 20 of the least profitable suburban routes with bus services, as the trains are running at less than 20% capacity. Nevertheless, it will not be possible to solve profitability problems in this way, as possibilities for cutting back on railway infrastructure are rather limited and, considering the low mobility of the population, this is likely to lead to negative social and economic consequences. As for other passenger traffic, the profit margins of different routes vary greatly. For example, route 45 from Lysychansk to Uzhhorod is the most troublesome: according to UZ, it suffered losses of UAH 98.8 million ($3.5m) in just the first six months of this year. However, it is important that it be supported for social and political reasons, as it ensures the mobility of the population in a strategically important direction.

As for freight traffic, the company has already started to talk openly about the need for compensation. In particular, they insist on the introduction of a special tariff for loss-making stations or the reimbursement of losses, either by local authorities or other stakeholders. According to the company, there are around 300 stations that dispatch less than two cars of grain a day, which does not cover maintenance expenses. In fact, this is no longer only an idea: since 1 July 2018, grain shipments have been totally or temporarily suspended from 92 stations (19% of the total), through which only 1.5% of grain passed in 2017. It is a controversial issue whether UZ will be able to come to an agreement with local authorities, as the experience of suburban passenger traffic shows there is a lack of understanding. It is even more doubtful that the government will hurry to meet the company halfway, as their relationship in recent years has been rather tense. Minister of Infrastructure Volodymyr Omelian claims that corruption in the company is worth UAH 15 billion ($535m) each year and passenger transportation "is not as unprofitable as is sometimes declared". However, there is more evidence than only statements from officials. Investigative journalism has also shined a light on corruption in the company, as have cases opened by the National Anti-Corruption Bureau: as of September, 17 cases concerning UZ were being worked on. For example, a contract for the purchase of General Electric locomotives worth more than $1 billion, concluded by UZ in February, is currently under investigation. In turn, Yevhen Kravtsov claims that the Bureau "was forced to file a case" and therefore the company is not worried about it. Next year, the Accounting Chamber is supposed to begin an audit of the company, which could set the record straight about the railway monopolist's actual position. In any case, state subsidisation will only make sense if the funds are used transparently and efficiently. For now, there are no two ways about it: as long as a cloud of corruption hangs over the railways (and relations with the government are not harmonised), such an initiative will never make practical sense or have political and public support.

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Relations between UZ and manufacturers are also extremely problematic – the latter are irritated by not only the growth of tariffs, but also the inability of the company to adequately meet their needs. Last year, an automated distribution system for freight cars was introduced that, according to Andriy Riazantsev, Director of Economics and Finance at UZ, made it possible to immediately increase freight volumes by 25% while barely expanding the wagon fleet. But this was not enough: according to IMF Group, last year farmers alone suffered losses of $321m from being forced to transport their grain by road. UZ states that there have been no complaints in the current sales season and there should be enough grain carriers for another three to five years. However, this opinion is not shared by everyone. For example, the Ternopil Regional State Administration announced at the end of October that the region had only received 482 of the 3,000 grain carriages it required. However, the sharpest criticism of the railways this year has come from metalworkers. At the end of August, president of the Ukrmetprom association of steel-making companies Oleksandr Kalenkov stated that cargo transportation was in a critical state, as a result of which mining enterpriseshad their warehouses filled 4.5 times over capacity and were faced with a need to reduce production. UZ denied these claims, calling them a "smear campaign". Be that as it may, all this controversy is not addressing the issue of wear to freight cars, which, according to various estimates, is measured at between 84 and 99 percent. Predictions from the IMF Group show that if the deficit in rolling stock is not bridged in the next five years, the Ukrainian economy risks losing up to $27.8 billion (at 2017 prices), or 4.8% of annual GDP. Is UZ capable of warding off such a scenario? According to the Ministry of Infrastructure, there are 65,000 freight cars in operation. Yevhen Kravtsov adds thatthe company built 2606 in 2017 and another 1704 in the first half of 2018. Production has also picked up at the Kriukiv Manufacturing Plant, which shipped 2614 units between January and September. UZ will receive another 7,000 in 2018-2019 thanks to cooperation with the EBRD. In short, hope that at least this problem can be addressed in a more or less timely manner is well-founded. However, the other complex issues do not have such a simple solution. It is quite obvious that the company must improve its management standards and root out corruption. Nevertheless, without state support, in particular in the form of subsidies, chances for the rail monopolist to become an agent foreconomic growth and social welfare in Ukraine are remote.

Translated by Jonathan Reilly

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